Response:  Here are a few things to think about as you trade options or learn how to trade options, and ponder the interrelations of the underlying index, implied volatility and strike price placement when you trade options on credit spreads and iron condors – for  these option trading strategies:

1)    Implied volatility of the underlying index is one of the values used to calculate the price and probability of an options leg expiring ITM (in the money) or OTM (out of the money)

2)    Implied volatility for the RUT (Russell 2000 index) is RVX, and as of this writing it’s around 36

3)    Implied volatility for the SPY (and ETF that tracks at 1/10^th the value of the S&P 500 Index – SPX) is the VIX and it’s around 26

4)    Because the implied volatility for the RUT is higher, the RUT moves a larger % on a daily basis as compared to the avg % daily move of the SPY, so this is why we can get a larger % distance between our short calls and puts on the RUT when opening an iron condor – this option strategy

5)    The return on a RUT credit spread is calculated as follows, using the example of having $1000:  Let’s say we bring in 70 cents credit on the RUT Dec 640/650 bull put spread; this is a 10 point wide spread where each spread requires $1000 of maintenance; thus we are able to open qty 1 of this spread, and we bring in $70 of premium; our risk capital is $1000 – $70 = $930; our potential return on this trade is 70/930 = 7.5%;

6)    The return on a SPY credit spread is calculated as follows, using the example of having $1000:  Let’s say we bring in 13 cents credit on the SPY Dec 115/117 bull put spread; this is a 2 point wide spread, where each spread requires $200 of maintenance; thus we are able to open qty 5 of this spread, and we bring in $13 x 5 = $65 of premium; our risk capital is $1000 – $65 = $935; our potential return on this trade is 65/935 = 6.9%

7)    In general, the risk/reward nature of the majority of our credit spreads is the same, whether it’s a 10 point wide spread on the RUT (Russell 2000 Index), a 5 point wide spread on the MNX (NASDAQ 100 index) or a 2 point wide spread on the SPY (S&P 500 index) where each has an 87% to 91% probability of expiring OTM and profitable, the bottom bull put spreads bring in about 5% to 8% in 30 days or less, and the top bear call spreads bring in about 3.5% to 5.5% in 30 days or less.  As a result, when the bottom and top credit spreads are combined to create an iron condor, the overall potential ROI is about 8.5% to 13.5% in 30 days or less.

Answer:   Periodically, we’ll have a short term spike or sell-off in the underlying index in the last two weeks of trade before expiration giving us a final chance to open some additional spreads.  So in the last few weeks of trade, I continue to show the currently recommended strike prices and price ranges, even though there is a low probability that we’ll have another opportunity to open more spreads.  In general, when we are down to the last 2 weeks of trade before expiration, premium usually dries up and we won’t have the opportunity to open additional credit spreads.  (especially for the top spreads)    We do monitor the recommended strike prices and credit price range daily and we’ll move them up or down, or remove them completely when the risk/reward characteristics of the trade no longer make sense.    

Per opening credit spreads that are 5 weeks in duration, yes, it usually works and you can bring in excellent levels of premium.  However, just due to how the market has been behaving in the last 4 months, I’ve shied away from 5 week trades and have focused on 2 to 4 week trades to reduce the time exposure risk.  We are also able to open shorter duration, 2 to 4 week credit spreads because volatility, VIX, is elevated making them more expensive and allowing us to bring in higher levels of premium.

Response:     I understand your concern.  In general, because we open very far out-of-the-money (OTM) 90% probability credit spreads, we tend to have enough time to close out our bull put spreads and/or make adjustments to cut our losses in the case of a market meltdown.   99% of the time, even when the market pulls back hard, we have time to get out and cut our losses, and we have a 5 year track record of keeping our losses below 10%, which is pretty good.

However, the October 2008 crash was different where we unfortunately ended up riding a few of our spreads down to where they went in-the-money (ITM).  This happened because in addition to the major indexes violently selling-off 3% to 5% per day, volatility also rapidly spiked up to record levels making it very expensive to get out of our spreads. We therefore decided to hold-on hoping for a short lived bounce so we could get out, but unfortunately that never happened as we all know.   So during the Oct ‘08 crash, we actually made very few adjustments to our bull put spreads, thus they they went ITM, and we were able to eventually get back 65% of our original risk capital purely by rolling our ITM spreads month-to-month, rolling down the strike prices of our spreads lower and lower each month, and waiting for the market to rebound a little.   This Oct ‘08 crash gave the MCTO team a good case study on what it takes to roll spreads and to recover a large % of risk capital after a massive crash.  It was painful to go through, but I’m somewhat happy that it forced me and my partner to become experts on rolling in order to preserve capital during a crash.

So per your concern of a one day, 15% or greater stock market crash where our bull put spreads immediately go ITM, we have a lot of experience with what it takes to roll spreads and we are confident that we can get back at least 60% of our risk capital, and possibly as high as 80% of our risk capital, depending on how fast the markets recover.  (An example of an event that would cause a one-day 15% crash is something similar to 9/11, or worse, the detonation of a  nuclear device in a US city by terrorists, which is the type of event that could take the markets down 15% or more in a single day)

Please keep this in mind as you interview other credit spread advisory publishers. Very few, if any, credit spread newsletter editors have experience in rolling.  Most don’t bother with rolling and just throw in the towel and let their subscribers lose 100% of their risk capital.  For us, that’s unacceptable and we fight to the end to preserve our capital using advanced rolling techniques that we practiced and refined during the Oct ‘08 crash.

By Brad Reinard, Editor-in-Chief, monthlycashthruoptions.com
Last Update August 2, 2009

Implied Volatility (IV) is a measure of how much the “market place” expects the price of an underlying stock or index to move; i.e. the volatility that the market itself is implying for the underlying stock or index. The VIX index represents the Implied Volatility for the S&P 500 index (SPX), therefore giving us a prediction of the potential size of future price swings for the SPX. Wall Street, in general, uses the VIX to represent the volatility of the stock market as a whole, and not just the SPX. One of the variables of pricing an option is IV. Thus, when IV for an underlying stock or index increases, the price of options on that stock or index increases. Conversely, when IV for an underlying stock or index drops the price of options on that stock or index decreases. For traders like us who write (sell) index credit spreads and iron condors, we like higher IV because we can collect more premium for the options that we write.

Implied Volatility (IV) is also called the fear index. When the market goes down the VIX goes up – i.e. investors are getting more fearful. On the contrary, when the market rallies, IV drops and fear subsides because investors start feeling more comfortable with the market. Therefore, there is an inverse relationship between the underlying index or stock and its IV. Figure 1 shown below demonstrates the inverse relationship of the Russell 2000 index (RUT) to the VIX. As you can see, when the RUT sells-off, investors get more fearful and the VIX climbs; and when the RUT rallies, investors feel more comfortable with the market and the VIX subsides.

Sometimes the VIX moves in the same direction as the underlying index or stock. Figure 2 below shows that in May, June, and July of 2007 the VIX trended upward along with the market. This is a sign that the market could be topping-out and is ready for a pause or correction. The psychology behind this is that even though the market is trending upward and “looking” healthy, investors are getting worried that the market is getting over extended and/or the fundamentals behind the economy are slowly deteriorating. Therefore, when we see the situation where the VIX (fear) trends upward along with an upward trending market we need to be careful and watch the market closely for a possible correction.

Another observation that we can see in Figure 2 is that the VIX many times will increase just prior to an event such as the Federal Reserve Open Market Committee meeting where they make the decision to either raise interest rates, hold them steady or lower them. The VIX climbs because there is uncertainty on what the outcome will be. This is what happened in late June, as shown, where the VIX spiked up to almost 19. However, as soon as the Fed announced their decision on interest rates and the uncertainty diminished, the VIX immediately deflated back down to 16. We sometimes want to time the writing of our credit spreads with events like this since the quick spike of the VIX will substantially increase the price of the credit spreads options that we are writing (selling).

To summarize, below are some general trading rules using the VIX when deciding to open 30 to 40 day index bull put credit spreads, bear call credit spreads or iron condor options: 1) If the VIX is holding steady and is not dropping from day to day when we are about 30 to 40 days out to expiration, we can usually take our time to open our spreads for that month and gradually “collect” premium over a two week period. 2) If the VIX is slowly dropping day to day when we are 30 to 40 days out to expiration, we then will have to move more quickly and open our trades before the premium of the credit spreads that we’re selling “dries up”. 3) Once we open our bottom bull put spreads, and if the VIX starts to creep up from the time we opened our trades, we need to closely monitor the VIX because it could be warning us that a “hurricane” is coming, where we might need to close our bull put spreads early and only focus on the top bear call spreads for that particular month.

About The Author
Brad Reinard is Editor-in-Chief of Monthly Cash Thru Options LLC, a leading index credit spread & iron condor options advisory newsletter, which has the following track record:   69% YTD 2009 (thru Aug); 33% 2008; 63% 2007; 42% 2006; 50% 2005.  For more information on the technical analysis that we perform on the S&P 500 and Russell 2000 (RUT) indexes, along with trading tips on iron condors and credit spreads please visit www.monthlycashthruoptions.com or call Brad directly toll-free at 877-248-7455.  Monthly Cash Thru Options LLC is located in San Jose, California, the heart of Silicon Valley.